The Government Bailed out Freddie Mac and Fannie Mae

In case you haven’t noticed, the economy is teetering on recession, unemployment is at a five-year high, and home foreclosures are at an all-time high. And for once, it’s not only the little guy who’s feeling the pain. The largest corporations on the planet – Citibank, Washington Mutual, and Merril Lynch, to name but a few — have had to turn to foreign governments to bail them out. And these same banks have dramatically scaled back their lending practices to shore up their balance sheets.

The problem is, the US economy and everyday people desperately need the banks to lend money. Banks are the lubrication that drives the US economy. They not only finance large and small businesses, which in turn hire and pay millions of workers in the US, but they also provide mortgages and personal loans to everyday people like you and me. And over the past 12 months, they have dramatically tightened their practices, more or less shutting down the mortgage market while driving home prices lower. With less housing demand, builders have collapsed, laying off their workers. With less equity in their homes and higher interest rates, defaults have skyrocketed, with many people walking away from their homes.

That has had a ripple effect on the overall US and world economies. In fact, we are on the verge of wide scale economic recession and corporate collapse, which could take an economic toll never seen before (e.g., Trillions of dollars!). Without government intervention, the US economy could see a downturn on the order of the depression of the 30s.

Who the Heck is Freddie Mac and Fannie May Anyway?

Freddie Mac (“The Federal Home Loan Mortgage Corporation”) and Fannie Mae (aka “the Federal National Mortgage Corporation”) are private corporations formed by the US government to add “liquidity” to the mortgage markets. That sounds complicated, but the idea is simple. Essentially, what they do is buy home loans from banks so that the banks can use that money to go out and make more home loans.

Then Freddie and Fannie generally sell “guaranteed” bonds paying a rate slightly less than the mortgage rates. The mortgage payments backed these bonds. As long as defaults weren’t too high, Freddie and Fannie got their 7% payments (for example) from the mortgages, paid 6% to bondholders and pocketed the difference.

The trouble is, default rates skyrocketed due to weak lending standards, and they were challenged in paying their obligations to bondholders.

At the same time, there has always been an implicit (but not explicit) US government guarantee of Freddie and Fannie. That guarantee has never been tested. Until today.

Enter Uncle Sam

The US government stepped in on September 7, 2008 and took over both Freddie Mac and Fannie Mae. Essentially they said what was obvious. These corporations had acted irresponsibly, took on too many risky loans, and did not have enough capital to continue operations, and additionally, have failed to continue their federally chartered mandate of providing liquidity to the US mortgage markets.

In doing so, the US government assumed responsibility for their liabilities, totaling roughly $6 trillion dollars. That is about half of the total mortgages of the United States, and is a staggeringly large figure. It is on the magnitude of the entire current debt of the United States accumulated over the past 200 years. It is conceivable that these two corporations could have losses of hundreds of billions of dollars, passed on to tax payers.

So why would the US government take such a measure? Because if they didn’t, the potential losses to the US economy could measure in the trillions of dollars, precipitated by a continued downward spiral of the real estate market, the likely collapse of multiple large banks (Citi, WAMU, etc) who are critical to financing future growth, and a resulting reduction of economic growth for 5 to 10 years to come.

In this light, the government’s action was spot on. The US economy and the everyday people of the US have suffered enough. By assuming relatively large liabilities, the US government has staved off disaster. As liquidity re-enters the mortgage market, home prices should stabilize and write-offs from the major banks should finally normalize as they can better value the loans on their books. And consumers should see eventual easing of lending standards.

While it’s a gutsy call, I’ll say it here: this action will be viewed as a brilliant move signaling the beginning of the economic recovery. This fall, the banks should finally turn the corner on their solvency uncertainties. The US housing price collapse will bottom out in early 2009. And as a result, the first half of 2009 will see the beginning of the next economic growth cycle.